Fed Ups Inflation Forecast; Signals End of Bond-Buying

(May 2, 2011) — The Federal Reserve expects that US inflation — which has been a primary concern for institutional investors worldwide — will surpass the target rate set by policymakers.

Last week, the US central bank announced that it anticipates headline inflation will reach 2.1-2.8% during 2011 before returning to the official target of under but close to 2% in the following year. “The [Federal Open Market] Committee expects the effects on inflation of higher commodity prices to be transitory,” chairman Ben Bernanke said during a news conference, according to the news service. “As the increases in commodity prices moderate, inflation should decline toward its underlying level,” he said, contrasting with earlier statements made by Jeremy Grantham, the co-founder of the US investment firm GMO Capital Management, who has said that it’s ‘time to wake up’ as the days of plentiful resources and falling commodity prices are a thing of the past.

Meanwhile, while Chairman Ben Bernanke acknowledged that long-term inflation projections remained stable, short-term price hikes have convinced the Fed not to continue its latest $600 billion stimulus program of asset purchases — dubbed QE2 — beyond its scheduled end in June.

“The trade-offs are getting less attractive at this point,” he said. “Inflation has gotten higher…it’s not clear we can get substantial improvements in payrolls without some additional inflation risk.”

Despite the Fed’s efforts to quell fears, investors have continued to voice concerns over inflationary pressures. In the UK, an April survey of 64 European pension schemes with more than $426 billion (€300 billion) of assets showed that inflation is the most pressing concern for investors, with 92% of respondents citing it as a slight concern or a serious worry.

On the other side of the pond, in the US and Canada, a heightened focus on inflation is reflected by an annual investment consultant survey from Casey Quirk & Associates and eVestment Alliance revealed that alternatives, emerging markets, and strategies that provide a hedge against inflation are expected to dominate 2011 search activity. The study showed that half of those surveyed expect an increase in institutional interest in inflation hedging strategies this year. “One of the more interesting findings in this year’s consultant survey is the rising interest in private equity and real assets,” noted Casey Quirk Partner Yariv Itah in a statement. “Institutional investors increasingly manage toward outcomes rather than just excess return, and they want asset managers who can use illiquid investments to mitigate inflation risk and manage liabilities.”

In response to US fiscal concerns, investors have been adjusting their allocations. Pacific Investment Management Co. (PIMCO), for example, has been increasingly shorting US government-related debt and raising its cash holdings, largely due to inflation concerns. In June of last year, Bill Gross, chief investment officer of PIMCO, revealed that he would be making a transition into equities. “We are recognizing that the global marketplace is not just bond-oriented, and so equities have a place, always have had a place,” he told CNBC. Mohamed El-Erian, CEO of PIMCO, who popularized the phrase “new normal” to describe how growth will be depressed by consumer retrenchment and tighter financial regulation, has said the Fed’s purchase of Treasuries will lead to faster global inflation while failing to revive US economic growth. Thus, he has warned that investors should expect lower-than-average historical returns with greater regulation, lower consumption, slower growth, and a shrinking global role for the US economy.